Property transfers in divorce are not necessarily tax-free, but they are tax-deferred. Section 1041 of the Tax Code treats property transfers in divorce much like gifts rather than taxable income. The same law applies to property transfers between married spouses and spouses who are getting divorced. When property is transferred between spouses, the transferree receives a “carryover tax basis,” which is equal to the transferor’s tax basis. For tax purposes, the tax basis is the starting point for measuring taxable gain. Carryover tax basis means that the property keeps the same value, for tax purposes, that it had when the transferor acquired.
When the property is sold by the transferee, there may be a taxable gain, measured by the difference between the sale price and the carryover tax basis. For instance, a stock that was worth $10 when a wife bought it is transferred to the husband when it is worth $15. Later the husband sells the stock for $17, and he will have to report a $7 taxable gain (not $2 gain). The holding period is also carried over. This is why divorcing spouses should agree to exchange tax basis information as part of their settlement agreements.
The non-recognition of taxable gains is also true for property transfers between former spouses, provided that their transfers are “incident to the divorce.” A transfer of property interests between former spouses that occurs within one year of the divorce is presumed to be “incident to the divorce.” If the transfer does not occur within one year, but occurs within six years after the divorce pursuant to a divorce or separation agreement, it will be considered to be “incident to the divorce.” For good cause shown, the Internal Revenue Service may waive the time period for property transfers that take more than six years..
Some clients make settlements where they agree to delay the sale or transfer of title to property (such as the marital residence) until years after the divorce (such as when the children graduate). It is important to document such arrangements in a written divorce instrument to ensure that the property transfer is qualified for non-recognition under § 1041, especially if the transfer is anticipated to occur more than six years after the divorce. Similarly, installment payments related to equitable distribution should be well-documented.
Frumkes & Vertz on Divorce Taxation contains a chapter devoted to the subject of tax-free property transfers in divorce. The transferred property, having carryover tax basis, might carry some tax liability (or tax benefit) for the spouse who receives it, an important point to consider when negotiating a marital settlement. The tax is not due immediately when the spouse receives the tax-free property transfer, but might come due when the property is sold or liquidated. Some common examples are a stock portfolio or a marital residence that has appreciated in value. These marital assets may carry income tax liability to the spouse who receives them, which must be paid when the stock or home is later sold.
Chapter 2 of Frumkes & Vertz on Divorce Taxation contains legal research and practical advice for family lawyers and their clients on making tax-free property transfers in divorce. Chapter 2 discusses the requirements for claiming the $250,000 exemption on taxable gains that is available when selling a principal residence, and how to pool the exemptions for married and divorcing couples. The book also contains tips on how to minimize the tax due when a divorce settlement calls for installment payments with interest; and tax traps involving the mortgage interest and real estate tax deductions for separated and divorcing spouses.
When it’s time to divide marital property without triggering unexpected tax consequences, you need the knowledge and experience to do it right. For more than 25 years, Brian Vertz has been structuring family law settlements and writing divorce agreements to achieve tax-free property transfers for his clients in Western Pennsylvania. His law firm, Pollock Begg Komar Glasser & Vertz, is one of the top family law firms in Western Pennsylvania. For effective help with divorce property transfers, call Pittsburgh family lawyer Brian Vertz at (412) 471-9000 or use our contact form.